The Year of the Dove
How to Make $ Out of a Surprising Dove
In a week that produced the most dovish Fed report since the days of 2014, two negative dents to recent hopeful Trade War sentiment and a similar downward shift in Brexit optimism, stocks and the Dollar remain resilient. NDX ramped to new highs and GBPUSD fell toward the bottom of the range. There are of course exceptions. Yield driven USDJPY has paid off shorts following the largest one-day drop in US yields for nine months. Similarly negative territory in Bund yields have dragged the DAX and EURUSD down and confirmed we will soon see a major buying opportunity at least in the single currency. As our pre FOMC report to subscribers stated:
"… we will be looking to fade a EURUSD spike up to end a slow but still well structured recovery and therefore only for a correction but that should take us well into next week.
Yesterday’s sell off in Indices prompted by the US official’s criticism of China allegedly rolling back some tariff agreement is now being attributed to front running a dovish Fed. Any such recovery in yields and the USD is also likely to trigger an upside reversal in stocks."
We also noticed something had changed. Neither SPX nor USDJPY, arguably the two key FOMC markets, were following the normal inflationary growth pattern. They were following an inversion.
It is ironic that this week’s main story– the Fed projecting no further interest rate rises in 2019 - is captured by an animal that symbolises peace and yet it produced a somewhat violent two way market. It is not surprising that, in such a beast of a market that traders are fond of animal analogies. Indeed, after years of an inflationary growth hawkish Fed and a seemingly one way stock and Dollar uptrend, you would think such a relatively quick change in the US central bank’s fundamental outlook would produce a one way Bear market. But the Bulls still have their day. Unless of course you are trading the German DAX which remains a dog that bites occasionally.
However, such animal analogies are misplaced because they paint a black and white narrative. As Jesse Livermore said.
What is the right side then, following the gloomiest Fed report that produced a 15-month new low in US 10 year yields? And it’s not just getting it right. After all we predicted the December rate hike would be the last in the tightening cycle that started in December 2015 despite the Fed projecting two further rate hikes in 2019. Its trading it right that matters and understanding how human nature and sentiment can often distort and twist a market to make trading appear only simple in retrospect. How then can we forecast and trade that retrospect? The answer as Jesse Livermore said over and over again, does indeed lie in the past.
With stocks generally ignoring deteriorating data but choosing almost the excuse of lower yields to rally further, there is a clear precedent for such a disjointed market that chooses to ignore the fundamentals, 2014, when falling yields drove stocks higher and the USD down.
In 2014, the stock market relied on falling yields to maintain a persistently bullish sentiment.
Whereas previously the Dollar rallied with stocks in this instance when the Fed deferred the end of Quantitative easing, the Dollar collapsed.
Since this represents an important break in a hitherto important market correlation, are there any other other relationship changes that could destabilise the market and create greater volatility?
It is a long standing market belief that FANGs and NDX suffer with rising rates and benefit from falling rates. Hence why NDX outperformed following Wednesday’s FOMC. However, FAANG (and growth) stocks can correlate with rates in different ways. The first, and perhaps most obvious, would say higher rates are a negative. Growth stocks typically have high PE ratios and duration, so higher rates brought on by inflationary pressures can and will weigh. Yet if short-term rates are rising faster than the more inflation sensitive long-term rates, it can be a good thing. This has been strikingly apparent since the 2016 election as illustrated by AMZN and 2yr yields.
FAANG stocks typically have no debt and when the economy is growing strongly prompting rate hikes it will be a positive if inflation is benign and the yield curve (10y-2y) is flattening. When the yield curve steepens, typically because the Fed pause/cuts on growth concerns but also because there is higher demand for short-term bonds and liquidity brought on by a desire for safety, it has been and should continue to be a negative. This can be seen in a comparison between (inverse) Apple and the 10/2 curve.
The Fed completely pausing the hiking cycle should have a steepening effect on the 10/2 curve as the Fed has most influence over short-term rates and is backing off because of growth concerns. This has happened before, when Ben Bernanke flipped dovish (he actually started out a hawk) in his first year as Fed Chair and signalled a pause in the spring of 2006. The yield curve bottomed soon after and turned higher as the Fed were later forced to cut.
A pause in 2019 could quite easily lead to a cut in 2020 which is an election year and also pencilled in by many to be challenging for US growth. Many are now forecasting a recession for February 2020. We have pointed out before, the inversion of the yield curve is not necessary before a recession, it is the steepening of the yield curve which is important. This is why we are paying close attention to the shorter term chart and the trend channel from the 2017 highs.
If the market remains fearful of recession, reflected by falling yields, then the leading NDX may start to lag the other US indices and provide some very exciting spread trades for the second quarter of 2019 where we can look to buy SPX or DJIA dips and sell NDX new highs. In this respect this week’s dovish Fed may not only be the trigger for such a turnaround but the standard NDX rotation with SPX and DJIA and could well help us time such trades.
2014 remains a very accurate template and one that should continue to help us buy SPX dips and sell NDX rallies but just as importantly sell Dollar rallies.
2019 is the Year of the Pig. This market may seem like a pig to trade at times. But 2019 is actually the year of the Golden Pig. It only comes once every 60 years and brings significant financial luck. With history and 2014 to help us, we are increasingly confident we can exploit this beast of a market.
Here’s to making the very best.
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